Question

A company makes only cash sales (i.e., it has no receivables). It currently sells 1,000 units per month at a sales price of $45 and a present value of costs of $35 per unit. Firm plans to allow credit sales to increase its sales to 1,100 units per month, in which case all sales will be made on credit and 5% of sales will end up being uncollectible after the 30- day payment period. If the discount rate is 1% per month, should the firm extend the credit? Assume that under credit sale, production costs were paid at the time of sale and that outstanding receivables have an average of one month.

Answer 1

Here we compare two options, Cash Sales vs Credit Sales. We will decide which is best for the organisation based on the contributions generated under both the options

Otion 1 : Cash Sales

Sales Price per Unit = $45

Cost per unit = $35

Contribution per unit = $10

Total contribution = $10 x 1000 units = $10,000

Option 2 : Credit Sales

Present value of Sales price per unit = $44.5544 ($45/1.01) (Given 1% discounting factor for one month)

Cost per unit = $35

Contribution per unit (in present value terms) = $9.5544

Total Contribution (in present value terms)   = $9.5544 x 1100 units = $10510

Less : Uncollectible Sales (Bad debts) = 5% x1100 x $44.5544 = $2450

So, Final Contribution = $10510-$2450 = $8060

Comparing both the contributions, Cash sales is better option as it yields more Contribution